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Which Trade Arrangements for the West Bank and Gaza?

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 1994
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AS THE West Bank and Gaza gain increasing autonomy, critical strategic choices emerge on the nature of economic links to the rest of the world, particularly neighboring countries. The April 1994 Protocol on Economic Relations between Israel and the West Bank and Gaza provides for a liberal trading environment that could help sustain the economy—indeed making trade a major source of growth.

In the past, growth in the West Bank and Gaza was largely sustained by earnings of Palestinian workers in Israel and in the Gulf countries. As this source of income is on a decline, employment opportunities within the West Bank and Gaza will need to be increased. The first steps toward Palestinian autonomy provide the opportunity, as well as the resources, to reorient the production base and to reduce the dependency of the Palestinian population on employment in Israel. But how should this reorientation in the productive base be effected? What growth strategy should be pursued, and what kind of trade regime would be consistent with this strategy?

The specific trade provisions in the Protocol on Economic Relations between Israel and the West Bank and Gaza, which was signed on April 19, 1994, generally preserve the overall framework of a customs union but allow significant exceptions that would help promote trade with the Arab world. But is this necessarily the best trade arrangement for the West Bank and Gaza? Assessing the provisions of the Protocol requires reviewing the external trade arrangements that would be most desirable for the West Bank and Gaza in order to achieve high and sustainable growth.

A desirable trade strategy

The choice of an appropriate trade strategy largely depends on the characteristics of the economy and geographical factors. Clearly, the option of turning inward would be very costly for a small economy such as the West Bank and Gaza. The limited domestic market and the need to establish reliable sources of sustainable growth provide little room for inefficient import substitution and “infant industry” type protection. Distances to neighboring countries are small, transportation costs are low, economic links with Israel are intertwined, and borders will be porous, particularly in the context of regional peace. Domestic production will have to be efficient from the outset, targeting potential effective demand for specific products in neighboring countries and at the regional level. Hence, the only trade strategy that can underpin a relatively high and sustainable growth would be an outward-oriented, export promotion strategy, which would maximize the gains from trade. While in the coming years residential construction and the buildup of infrastructure in the West Bank and Gaza may become major sources of growth, over the longer term, only exports can provide a steady and reliable engine of growth.

With this particular growth strategy, the trade regime acquires special significance. Two factors can make or break this strategy: competitiveness and market access. The trade regime must minimize investment costs of new production facilities while encouraging choices of techniques that would be consistent with the West Bank and Gaza’s resource base. Hence capital equipment, as well as inputs to industrial and agricultural production, need to be obtained from the cheapest sources. Moreover, access to markets in Israel and to other neighboring and industrial countries must not be hindered by tariffs, nontariff barriers, other trade restrictions, and subsidies.

Against these efficiency considerations, other factors must also be taken into account. A Palestinian entity would require, in addition to external aid, substantial budgetary resources to rehabilitate its social and physical infrastructure. As in most developing countries, such resources would have to come mostly from indirect taxes, including trade taxes. At the same time, trade promotion and regional integration would also require some degree of indirect tax harmonization with Israel and other neighboring countries, such as Jordan and Egypt, which have lower sales taxes than Israel and with whom trade relations may rapidly expand. Hence, the choice of the trade regime will have to strike the right balance between ensuring productive efficiency and other macroeconomic and regional objectives.

The way it was

During the Israeli occupation, the composition and pattern of trade in the West Bank and Gaza became severely skewed. The resulting sectoral distribution of output became equally imbalanced—the domestic productive base, particularly agriculture and industry, was suppressed, while services were encouraged. The trade regime between Israel and the West Bank and Gaza was characterized by the absence of barriers to Israeli exports to the West Bank and Gaza but strict restrictions on its exports to Israel, in particular on agricultural products. This unequal customs union also skewed the pattern of trade by confining most of the West Bank and Gaza’s external trade to Israel. In particular, while the West Bank and Gaza were economically integrated with Jordan prior to 1967, trade with Jordan was virtually eliminated except for some exports of agricultural products. During 1980–86, an average of 70 percent of the West Bank and Gaza’s exports went to Israel and an average of 80 percent of its imports emanated from Israel. Trade deficits in both agricultural and industrial products with Israel have resulted in merchandise trade deficits averaging $385 million per year in 1980–86 or about 20 percent of GDP (see table). The deficits were largely financed by a trade surplus in invisibles averaging $237 million per year in 1980–86, mostly in the form of export of labor services to Israel and to Gulf countries.

West Bank and Gaza need to diversify production and expand exports(selected economic indicators, 1993)
IsraelJordanWest Bank and Gaza
Billion dollars
GDP65.65.22.7
GNP64.75.03.7
Dollars
GDP per capita12,2621,1711,500
GNP per capita12,0931,1262,056
Percent of total
GDP by sector
Agriculture4.48.017.0
Industry30.220.48.1
Construction8.75.914.7
Services56.765.760.2
Exports/GNP22.425.07.3
Imports/GNP31.170.829.6
External current account deficit/GNP-2.1-13.0-10.9
Population (millions)5.44.41.8
Source: International Financial Statistics, IMF, and staff estimates.
Source: International Financial Statistics, IMF, and staff estimates.

The customs union with Israel was particularly unequal with respect to trade in agricultural products, an area where the West Bank and Gaza could claim a historical comparative advantage. Agricultural exports to Israel were limited to about $36 million per year in 1980–86, due to restrictions on vegetable exports. On the other hand, agricultural imports from Israel averaged $92 million per year in the same period. An important factor that adversely affected the development of the agricultural sector in the West Bank and Gaza was the Israeli government’s policy of subsidizing Israeli agriculture. Subsidies on factors of production used in farming, credit to farmers at concessional rates, export finance, and a minimum price level for several agricultural products through the intervention of marketing boards were provided. Total subsidies on Israeli agriculture, including imputed subsidies on water but excluding subsidies on credit, averaged about 32 percent of the value of agricultural output during 1984–90.

The extensive governmental support to Israeli agriculture contrasted sharply with the lack of support for agriculture in the West Bank and Gaza. Whereas irrigation water is provided to Israeli farmers at subsidized rates, the government has imposed substantial restrictions on the use of irrigation water in the West Bank and Gaza and has regularly diverted water from aquifers for use in Israel and by Israeli settlements. These policies have led to a relative decline in output as well as a deterioration in the quality of a number of agricultural crops, especially citrus fruits. In addition, Palestinian farmers receive no subsidies or tax rebates on their agricultural inputs, although they are subjected to the same high tariffs on the import of such goods as their Israeli counter-parts. In the course of time, these asymmetries have repressed the development of agriculture in the West Bank and Gaza. While the share of agriculture in GDP has fluctuated around 18 percent, much of it is of poor quality and destined for domestic consumption.

An objective of the agricultural strategy in the West Bank and Gaza should be to expand and diversify the production of crops for export, with a view to gradually transforming the agricultural sector into a stable source of foreign exchange. This will involve a gradual shift in the composition of agricultural output away from subsistence crops and toward a high value-added output mix (fruits, vegetables, and horticulture) as outside markets—in particular Israel’s and Europe’s—become accessible.

As for industrial products, although there have been few restrictions on exports to Israel, nontariff barriers were erected to limit such exports, largely through licensing and quality requirements. In addition, Israeli industry, as with agriculture, has benefited from subsidies. Industry in the West Bank and Gaza received no such support, and has been subjected to strict licensing regulations, discouraging the establishment of large industrial enterprises. Furthermore, Palestinian producers were not entitled to the tax rebates on their exports that the Israeli producers received on the VAT and customs duties paid on inputs.

A further constraint on the development of the industrial sector has been the absence of a developed system of financial intermediation. This has stifled risk taking and entrepreneurship, limiting investment largely to housing. The small scale of operations and the low ratio of capital to labor in Palestinian manufacturing have led to low labor productivity, which often could not justify the relatively high wages of Palestinian labor induced by the demand-pull effect of employment opportunities in Israel. This has resulted in an anemic industrial sector, mostly based on a cottage-industry type of manufacturing, with about 90 percent of all firms employing eight or fewer workers. The share of industry in GDP has stagnated around 8 percent since 1968, well below the range of 20 to 30 percent of other countries with similar income levels and significant agricultural sectors. It is thus expected that an export-oriented industrial strategy would lead to an increase in the share of industry in GDP, both by increasing the number of industrial enterprises and by expanding the scale of their operations and improving production techniques.

Which trade arrangement?

In light of the past asymmetries in trading patterns, what sort of trade arrangement would be needed to address these imbalances? The growth strategy envisaged for the West Bank and Gaza suggests that the underlying trade relations with Israel and neighboring Arab countries should evolve to facilitate the shift in the production mix, broaden the pattern of trade toward its Arab neighbors and other countries, and create a trade environment that will stimulate exports and promote efficient import substitution.

So far, the gains from trade have been essentially one-sided: Israeli agricultural products have penetrated large segments of the West Bank and Gaza market, and Israeli manufactured products have dominated it. In the face of this overwhelming market penetration, some Palestinians are prepared to erect tariff barriers against Israeli products, and reorient their external trade toward Jordan and Egypt. Given the contiguity and potential complementarity between Israel and the West Bank and Gaza, such an approach would result in major welfare losses for the West Bank and Gaza and, to a lesser extent, for Israel. But even beyond economic considerations, it would also jeopardize the peace process—since the best investment in a lasting peace is fostering strong economic relations that would benefit both sides.

The real challenge for the Palestinians, therefore, is to maintain free trade with Israel provided the impediments to the development of industry and agriculture are removed and the regulatory framework harmonized to enable the West Bank and Gaza to compete with Israel on equal footing. If these conditions are realized, the West Bank and Gaza should be able to recapture a sizeable portion of its own market and penetrate the Israeli market, which is about 20 times larger.

“…the only trade strategy that can underpin a relatively high and sustainable growth would be an outward-oriented, export promotion strategy, which would maximize the gains from trade.”

A first step for the Palestinian Authority would be to liberalize trade relations with Israel, as was done under the Protocol, and establish a level playing field for the two economies on trade in goods and services. In particular, the removal of nontariff barriers, such as unduly high specification standards on certain industrial products, would need to be negotiated to facilitate the expansion of industry in the West Bank and Gaza. At the same time, given Palestinian development objectives, imports of capital goods and intermediate products should be obtained from the lowest-cost producers with minimal customs taxation. This is essential to minimize fixed investment costs, ensure the appropriate factor proportions, and help the economy of the West Bank and Gaza establish areas of comparative advantage. On the other hand, in order to encourage savings and provide revenues to the budget, the Palestinian Authority would need to impose relatively higher indirect taxes on consumer goods.

With these objectives in mind, should the West Bank and Gaza establish a customs union with Israel or a free trade area? Under a customs union, the West Bank and Gaza and Israel would maintain free trade between them and have a common external tariff vis-à-vis the rest of the world, whereas under a free trade agreement, the two countries would maintain free trade between them but adopt separate tariffs vis-à-vis the rest of the world. An important advantage of entering into a customs union arrangement is its ease of administration. The Palestinian Authority would not have to formulate a new customs tariff, erect border posts in Israel, have its goods inspected by Israeli border posts, or lose budgetary revenues. It would only need to set up a small customs administration to collect customs directly on imports coming through the Jordanian and Egyptian borders, and set up revenue sharing arrangements of trade taxes with the Israeli authorities. With a high premium on scarce administrative resources in the West Bank and Gaza during the initial restructuring phase, this approach would facilitate a quick and well-funded empowerment of a Palestinian tax and customs administration.

On the negative side, however, opting for a customs union would mean that the West Bank and Gaza would have to adopt the same tariff structure prevailing in Israel. To the extent that the Israeli tariff protects Israeli producers from outside competition, it becomes a tax on the Palestinian producer if the product is used as an input, and a tax on the consumer, entailing both an efficiency and welfare loss. For example, tariffs on durable consumer goods are as high as 70 percent in Israel. With more than 20 percent of gross industrial output in Israel consisting of durable consumer goods, the tariff brings substantial gains to Israeli producers, whereas, with no durable consumer goods produced in the West Bank and Gaza, no such gains accrue to Palestinian producers. Therefore, the trade diversion costs for the West Bank and Gaza (i.e., using Israeli products versus cheaper foreign products) may be significant, and the trade-off between the gains from trade creation versus the losses from trade diversion may be more favorable to Israel than to the West Bank and Gaza. Israeli tariffs on investment goods—averaging 21 percent—would also be higher than what developmental objectives in the West Bank and Gaza would warrant. However, Israel is now engaged in a process of trade liberalization, through which quantitative restrictions have been eliminated and tariffs are expected to be reduced to maximum rates of 8 percent to 12 percent by 1998. Provided this liberalization proceeds on schedule, the trade diversion costs of a customs union would be short-lived and worth bearing.

A free trade agreement, on the other hand, would allow the Palestinians to structure their own external tariff, taking into account their own developmental needs. However, the design of a new tariff and setting up a customs administration to collect customs duties on all imports would take considerable time and resources. Moreover, the Israeli authorities would want to ensure that third country products do not enter Israel through the West Bank and Gaza at low tariffs. The Palestinian authorities would also need to establish their own rules of origin. Defining “domestic content” and enforcing such rules of origin can be unnecessarily contentious in an environment where confidence building steps—which are essential for the success of the Peace Accords—should be emphasized.

The Protocol agreement

The trade regime established under the recently signed Protocol on Economic Relations addresses many of the concerns expressed above. Essentially, the Protocol has adopted the best features of a customs union and a free trade area by creating a liberal trade regime. It establishes a customs union between Israel and the West Bank and Gaza where the Israeli import tariff, other trade taxes, as well as import licensing and standards, have been accepted by the Palestinians for most imports. The Protocol allows goods to move between Israel and the West Bank and Gaza without any customs duties or import taxes (quantitative restrictions, however, will still apply to six agricultural commodities but will be phased out by 1998). Customs duties and other trade taxes collected by the Israeli authorities would be remitted to the Palestinian Authority for the goods imported by the West Bank and Gaza on a net basis according to the “destination principle.”

Two important exceptions, however, have been introduced in the customs union with Israel. First, the Palestinian Authority has been allowed to establish its own import policy and tariff structure for certain products and countries. A first step at diversifying the pattern of trade in the West Bank and Gaza was taken by the Palestinian Authority in developing trade ties with Arab countries. For this purpose, two lists of goods have been established: a list of goods locally produced by Jordan, Egypt, and other Arab countries, and a list of foodstuffs to be imported from Arab and other countries. The Palestinian Authority will determine customs policy and procedures with respect to these two lists, including tariffs and other charges.

Second, the Authority will also determine customs duties and other taxes for goods imported (capital equipment and wood products) for their economic development program. Further, the Authority will be able to impose its own tax rates on motor vehicle imports, which are a major source of budgetary revenue for the countries of the region, and to import petroleum products—which it can obtain at cheaper prices than Israel—for sale in the areas under its jurisdiction at prices that it can set, with the exception of gasoline. The price of gasoline would remain within 15 percent of the Israeli price to prevent arbitrage operations.

In sum, the Protocol can potentially succeed in addressing several Palestinian concerns:

• It opens up the Israeli market to agricultural products and other goods subject to the restrictions mentioned above that, in any case, will be phased out.

• It diversifies external trade in the West Bank and Gaza by establishing direct economic links with Arab and other countries; in particular, it establishes a bridgehead toward restoring the broad economic relationship that existed with Jordan prior to the occupation.

• It gives the Palestinian Authority the opportunity to import capital equipment and foodstuffs from the cheapest sources and impose its own low tariffs on these imports. On the other hand, there will be inputs, particularly to agriculture, that are not included in the three lists defined by the Protocol, and that will continue to be subject to the Israeli tariff structure. The impact on resource allocation of these customs duties (versus Palestinian duties) is open to question but, in any case, is not expected to be large.

• It provides the Palestinian Authority with tax handles by allowing it to set its own taxes on motor vehicles, petroleum products, and consumer appliances imported from Arab countries. At the same time, the Authority will collect trade taxes on all other imports from Israel, thereby sparing the Authority considerable administrative expense and problems in setting and collecting trade taxes for all imports.

On the other hand, the Protocol appears to have a number of limitations that are worth mentioning. First, imports from Arab countries will be limited by “market needs,” as determined by a Palestinian-Israeli Joint Economic Committee, established under the Protocol. Some of these imports can only originate from Egypt or Jordan. These restrictions could be gradually liberalized in the context of broader regional trade arrangements, including with Israel, which would be established once a comprehensive peace is attained.

Second, while the Protocol establishes free movement of goods between the two sides, it does not address the wide array of subsidies and other nontariff barriers that benefit some Israeli sectors and products. Presumably, the Palestinian Authority would be free to provide similar protection to its own production, but this would go against the elimination of distortions that should govern trade liberalization and would also entail budgetary costs. A more efficient approach would be for Israel to scale down its own subsidy system and restrictive practices, starting with commodities competing with Palestinian products or set up a compensation system for Palestinian producers.

Third, the thorny issue of access to water and water charges has not been addressed and would presumably be left for settlement after the peace process takes hold. Yet, as water is a major input to agriculture and industry, the establishment of equitable water rights and the setting of “economic” water charges will be essential for an optimal development of both Palestinian and Israeli agriculture.

Finally, land is another important factor of production that is critical for the expansion of the Palestinian productive base and residential construction. About 40–50 percent of land in the West Bank and Gaza has been transferred to the Israeli authorities following the occupation. While it will take some time to fully resolve this highly sensitive issue, it would be helpful, as a confidence-building measure, for the Palestinian Authority to recover some of this land and establish clear land registration practices.

Conclusion

Establishing economic autonomy and self-sustaining development in the West Bank and Gaza means diversifying trade patterns and relations, shifting from dependence on remittances from the export of labor, that are now in decline, to a broader production base and interdependence with other parts of the region and the world. The options with regard to retaining a customs union with Israel or establishing a free trade area suggest that both have costs and benefits, and some elements of each may not be politically feasible in the short term. Hence, some form of intermediate position would be both preferable and feasible taking into account Palestinian development and trade objectives. Notwithstanding its limitations, the Protocol achieves such a position, establishing a liberal trade environment that would be consistent with an export-oriented growth strategy for the West Bank and Gaza. More important, it can serve as a cornerstone for further trade liberalization and diversification that would help foster greater economic integration. Whether the Protocol can achieve this potential will largely depend upon additional measures, which redress some of the existing imbalances, particularly with respect to removing some nontariff barriers, establishing equitable access to water, and devising a system for fair property settlements.

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